Financial Stability Report June 2016

The Bank of Israel publishes the semi-annual Financial Stability Report

· The stability of the banks and the insurance companies was maintained during the period reviewed in the report, despite the fluctuations in the global financial markets and domestic events. The capital ratios of the banks and the insurance companies improved.

· The financial institutions are exposed to the risk of a sharp decline in the prices of homes and financial assets, whether as a result of an additional global recession or as a result of a return of the interest rate to an upward path.

· In the future, the financial system will be impacted by the manner in which reforms currently at various stages of debate and legislation will be implemented. The reforms must be conducted cautiously since the financial system fulfills a central role and a crisis in that system will bring with it a significant risk to the economy.

The Bank of Israel is today publishing the semi-annual report on the stability of the domestic financial system. The analyses in the report relate to events that took place until the end of June 2016. The publication of the Financial Stability Report is anchored in the definition of the Bank of Israel’s role pursuant to the Bank of Israel Law, 5770–2010—to support the stability and orderly activity of the financial system—and is accepted practice among the central banks of advanced economies.

The Financial Stability Report includes a survey of the risks to financial intermediaries at the core of the financial system—the banks and insurance companies—and a survey of the risks faced by the nonfinancial business sector and households, and the exposure of the financial system to these risks.

According to the report, the domestic financial system maintained stability in recent months, against the background of the accommodative monetary policy in Israel and around the world, and despite the fluctuations in the financial markets and the continued domestic security incidents. The banks and the insurance companies remained stable: In 2015, the profitability of the banking system increased, mainly as a result of specific and one-time developments, and the capital ratios of the five banking groups increased. A macroeconomic stress test on the banking system shows that even if a serious recession were to take place in Israel, the banking system would maintain its stability. While the profitability of the insurance companies declined during the period, their recognized equity increased.

Since the interest rate environment has been low for a prolonged period—a necessary policy in view of macroeconomic developments—and since it has a prolonged effect on asset prices, the financial institutions are exposed to the risk of sharp declines in the prices of homes and financial assets. Such declines may take place if main economies in the world shift to a further recession, or suffer from a decline in their financial stability, and there is contagion to the Israeli economy through a negative impact on exports and the prices of financial assets. Such declines may also take place if the central banks return interest rates to an upward path, or if Israel’s geopolitical situation worsens and leads to an increase in the risk premium of the economy.

The risk of sharp declines in home prices is derived from the fact that the banks are characterized by high exposure to mortgages and to the construction and real estate industry, and prices in this market continue to increase. The risk of declines in the prices of financial assets is derived both from the possibility of a direct impact—through holdings of those assets—and from the possibility of an indirect impact, through the effect of these asset prices on firms’ abilities to repay loans they took out from banks and from institutional investors.

In the future, the financial system will be affected by the manner in which the various financial reforms are implemented. These reforms are intended to improve the functioning and efficiency of financial intermediaries—an important component of all activity in the economy. However, they must be conducted cautiously since the financial system fulfills a central role in the economy, and a crisis in the system carries the potential of a significant negative impact to the economy.